June 15, 2022 - 9:58am EST by
2022 2023
Price: 17.30 EPS 2.3 2.6
Shares Out. (in M): 61 P/E 7.6 6.7
Market Cap (in $M): 1,050 P/FCF 0 0
Net Debt (in $M): 786 EBIT 230 265
TEV ($): 1,830 TEV/EBIT 7.9 6.9

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Orion Engineered Carbons (Ticker: OEC) has been written up on VIC twice: by jet551 in 2017 and juice835 in 2018. We refer you to both reports for background on the company, its history, and management. Following Orion’s first Investor Day as a public company on June 8th, 2022, we thought it would make sense to provide an update. 

Orion has two segments which are both inflecting while a large capital and regulatory investment cycle is coming to an end.

·        The rubber business, which provides a critical input to manufacture tires, was already in a tight supply/demand environment before the Russia-Ukraine conflict. The conflict has disrupted the supply of rubber carbon black in Europe and led customers to put an emphasis on security of supply. Even in a recessionary environment where demand slows, EBITDA decline could be limited given how tight rubber carbon black supply is globally without Russia and the fact 60-70% of all tire demand is for replacement tires, which are less cyclical than new OEM production. 

·        The specialty business is inflecting after adding capacity in Europe, China, and the recently announced expansion of their new acetylene product. Acetylene black demand is benefiting from the rapid growth in demand for lithium batteries. 

·        Over the next three or so years Orion can almost double EBITDA and generate more than half its market cap in cash.

·        These are multi-year tailwinds that have just begun to inflect. Orion has raised the upper end of its guidance range for 2022 and there is a good chance they can meet or exceed the current street estimates of $334mn of EBITDA.

Despite these positives, the perception of Orion is that it is a cyclical chemical commodity producer in a GDP growth industry at best and at $17.3/share, and 5.5x 2022 and 5.0x 2023 EBITDA, shares are already priced for a bad outcome. However, de-bottlenecking in gas black and the recent announcement of its Kappa acetylene expansion demonstrates that Orion’s specialty segment has high-return growth projects, which will help change the narrative. Finally, Orion was significantly capital constrained because of mandatory EPA related capex in the United States and growth capex over the last two years. That is no longer the case, and to hit Orion’s mid cycle Adj EBITDA goal of $500mn by 2025, the company needs to spend just $80mn of growth capex on Kappa in 2023 and the final $25mn of EPA related capex. Beyond maintenance capex, the necessary capex for growth has been spent. The combination of long-awaited free cash flow inflection, improved earnings capacity, and higher incremental ROIC will help improve Orion’s multiple.

In a poor tape, a small cap chemical company with exposure to Europe, China and the automotive industry will likely remain volatile, but based on the current industry and macro environment, Orion’s 2022 and 2023 earnings should be more resilient than the market believes. On a mid-cycle basis, Orion trades somewhere between a 20-25% FCF yield and below 4.0x EBITDA. In addition, we believe that the company that can meet or exceed guidance in 2022 and meet or raise the bar for 2023. While we don’t believe the company is for sale today, and would be disappointed with a take under, we believe the longer the disconnect between Orion’s growing intrinsic value and market value remains, the more likely the company is subject to activism or strategic alternatives. 

 Investor Day Summary

On June 8th, Orion held its first investor day since going public in 2014. Highlights of the analyst day are below:

·        2025 Mid Cycle Adj EBITDA earning capacity will increase to $500mn from $280mn LTM

·        Discretionary cash flow: defined as Adj EBITDA less maintenance capex, interest, cash taxes is expected to be between $750-850mn cumulative between 2023-2025

o   This is against a current market cap of $1.05bn and EV of $1.83bn, excluding the pension deficit of $73mn

·        To achieve $500mn of earnings power, Orion only needs to spend $80mn in 2023 to complete its Kappa Acetylene project which will supply critical elements to lithium-ion batteries

·        From a base of 2021, Adj EBITDA is expected to grow 17% per year

·        On an LTM basis Orion has done $280mn of Adj EBITDA and trades 6.5x LTM Adj EBITDA and just 5.5x at the midpoint of 2022 Adj EBITDA.

·        In 2019, Orion was a $35 stock trading at over 8.5x EBITDA.

o   Cabot, Orion’s most direct peer trades at 7.5x

§  With cash flow inflection coming and end to EPA capex, there is no reason Orion should trade at such an extreme discount


We think three things have led to a depressed share price at Orion:

1. EPA capex overhang

2. Perceived lack of growth that ignores the quality of specialty business

3. Lack of free cash flow

However, three things are changing should improve perception of the company and lead to multiple expansion

1. Structurally improved pricing and profitability in commodity rubber black will increase margins and returns on capital

2. Organic re investment in high margin and high barriers to entry specialty carbon black

3. FCF inflection as capital constraints unwind

EPA Capex and Russia: Structural Improvement in Industry Returns on Capital

The rubber carbon black industry will benefit from improved returns on capital for the foreseeable future driven by capacity constraints, strong demand, difficulty transporting material to limit imports, and a pushback on Russian volumes. The structure of the industry and cost of environmental compliance has permanently increased the barrier to entry and return on capital potential for Orion’s rubber black business. Despite operating at rubber volumes 5-10% below 2019 levels (cyclical upside) Orion has demonstrated they can not only increase base pricing but improve variable contribution margin to drive a return on a capital and improve EBITDA and free cash flow generation in the segment that had been a laggard. 


EPA and North America

As a result of poor judgement from prior management, cost escalations, and Covid delays, the final cost of the EPA related capex is expected to be around $290mn at the mid-point. Orion spent $95mn in 2021, will spend $70mn in 2022 and $25mn in 2023. Given that initial estimates back in 2018 were as low as $110-$140mn, the increase consumed nearly all Orion’s 2021 free cash flow. Orion did receive $80mn from former parent company Evonik, but that was barely acknowledged as investors focused more on the increase in capex and lack of cash generation.

The rubber carbon black industry is composed of regional oligopolies. Given the cost to transport the material over long distances, imports of carbon black are limited and often of low quality. The US rubber black industry has five producers and about 1,700kmt of capacity.  EPA compliance costs in the US raised the barriers to entry and limited the potential for new capacity. Even if a new carbon black facility could be built and permitted, which is almost impossible, it would take 3-5 years to build. It has been reported that Continental Carbon at its Phoenix City location has chosen not to install required equipment to meet EPA compliance an estimated 5% of capacity will come offline at the end of 2022. We have already heard they are slowing down, which adds to a tightening North American market. Giving the onshoring of tire capacity over the last decade in North America, the market is extremely tight and only getting tighter. One new entrant, Monolith, which generates its carbon black as a biproduct of hydrogen production, won’t be producing until late 2024. At full production of 194kt, Monolith, will make soft carbon black, which is in less desirable than hard carbon black, which is used in tread applications. Once online, Monolith’s supply will simply plug the demand gap and help displace any imports in a still extremely tight market.

Russia has been the main source of imports of carbon black into the US. Those volumes are not coming. Mexico and Canada have some ability to export to the US but not nearly enough to bridge the near-term demand gap. Asia or India could fill some of the gap but with shipping costs of $100-$200/ton and an EBITDA/ton of just over $225 before transportation costs within the US, it seems unlikely the arb is wide enough today without significantly higher base prices. Further, at last year’s Carbon Black World conference in the fall of 2021, a speaker gave a presentation on a shortage of specialized rail car capacity needed to move carbon black, which is a dusty, nasty product to move.


The chart below from Orion’s analyst day sums up how tight the market currently is in North America (including Mexico (185kt) and Canada (230kt). 


Due to the gap between demand and supply, we believe Orion’s rubber black division’s profitability is inflecting. From 2021 to 2022, based on our analysis and confirmed by the company’s guidance, we believe Orion can grow Adj EBITDA from $120 in 2021, to over $170mn in 2022, or 42% y/y on just 7% volume growth with most of the increase coming from pricing and improved Gross Profit/Ton. The best way to demonstrate this it to look at it visually. Given rubber black is primarily a pass-through business, the Revenue/Ton metrics will fluctuate with the oil price (proxy for feedstock). As we see from 2012-2018, there was not much pass through from rev/ton to gross profit/ton. However, starting in 2018 and 2019, Orion began to get increases in base pricing to start to earn a fair return. For 2022, Orion has guided Gross Profit/Ton to be in the $330-360/ton range despite volumes that are still below 2019. At the analyst day, Orion made it clear that this isn’t the peak in gross profit/ton and they expect that price and gross profit per ton will continue to increase.

One of the things that CEO Corning Painter demands of his employees is that they understand as a supplier of critical materials, Orion entitled to earn a fair return on capital. As the costs to ensure adequate supply went up due to EPA related Capex, the price Orion needs to earn a return went up as well. Orion shifted from volume based to return based metrics for sales incentive compensation. Orion’s head of Rubber Black North America, Pedro Riveros, came from Air Products where he worked with CEO Corning Painter. Pedro and Corning have been instrumental in changing the culture and arguably the industry in the US regarding pricing and return. Orion has already begun negotiating pricing for calendar year 2023 with tire customers. These negotiations typically take place in the fall but in each of the last two years, the conversations have started taking place earlier. Last year we estimated in North America Orion got between $0.08-$0.10c/lb of base price, an increase or 13-16% on year prior.



Even before Russia invaded Ukraine, the European rubber black market was extremely tight. While a human tragedy, the Russia and Ukraine War benefits the European carbon black suppliers. Russia accounts for about 1mn MTs of production out of 18mn globally and Europe gets about 35-40% of its carbon black from Russia. Following the war in Ukraine, European tire manufacturers are scrambling to secure supplies. Many companies and their employees don’t want to be associated with using Russian carbon black. Not only are people rejecting it based on their aggressive military actions, but from an ESG perspective, continuing to take material from a country with no regard for emissions for key feedstock is not a great look. What is actually happening on the ground remains unclear. Some carbon black is making its way into Europe via Turkey, and given India’s purchases of oil, it is likely that Russian carbon black ending up there as well. Imports from Asia into Europe have increased but tire companies continue to favor local suppliers and alternative supply agreements to rapidly displace Russian volumes.  Things are so tight that Orion has customers that are paying the freight to ship plane loads of rubber carbon black from South Africa into Europe. 


Outlook for 2022 and 2023 in Rubber Black

Orion is effectively sold out on capacity for 2022 and 2023 based on customer volume commitments. Further, Orion had already planned to complete a facility in Ravenna, Italy to make a combination of furnace black specialty and rubber grades. The 25kt facility was to be about 75% specialty furnace black, but following the recent issues in Europe, the company contracted with customers to run 75% rubber. Importantly, they ramped the facility up rapidly and by March of 2022, the facility was running full out. We expect the facility to generate about $12mn of EBITDA per year once fully ramped. Of note, Orion took the rubber volumes as they were able to get similar pricing to what they were to receive from the specialty customer – a sign of what customers are willing to do to ensure supply.


We believe investors are underestimating the inflection in profitability at the rubber black segment to a structurally higher level. While a commodity business, carbon black is an essential product with few substitutes, rapidly improving barriers to entry, and attractive returns on capital given limited capacity additions. Importantly, Orion can and will earn a return on capital form its EPA cap-ex investment. We have pegged at least $50mn or so of EBITDA to get a 10% return on capital from the EPA cap-ex of $290mn. Of the $125mn increases in rubber EBITDA from 2021-2025 laid out by Orion at its investor day, we estimate, at the mid point $90mn was from price, volume and mix with a significant chunk occurring in 2022. Of this, we think just 20% is volume, with the remaining is price and improved variable contribution margins. 



Specialty is Special: Investor Day Makes Clear Specialty Carbon Black is a Gem

Orion is the number one producer of specialty carbon black in the world with a 25% market share by volume and an estimated 40% share by value. This is driven by Orion’s legacy gas, lamp, thermal and acetylene black production process. For the first time at the investor day, Orion broke out how much these differentiated production technologies contribute: $80mn of EBITDA at a 40% margin.  Orion is the only company in the world capable of making carbon black from gas and lamp back. This is part historical accident and part because competitors simply can’t replicate the process and product at exacting results that customers demand.

A misperception of the specialty business is that while it’s a quality asset, there is limited growth. Orion spent much of COVID and the pandemic working with customers to get qualified on new products and formulations, which are beginning to flow through in 2022 and 2023. At the investor day, Orion provided photos of a facility in Cologne. The plant is fully equipped with testing, an R&D facility, and a pilot plant. The ability to prove a concept from design to production, manufacture it an exacting quality and then scale, is rare. Orion expects specialty carbon black volumes to grow 4-5% per year over the next few years, with coatings and battery related demand growing even faster at 6-15%.

With respect to growth in gas black, Orion will spend $20mn of cap-ex in 2022 to debottleneck parts of its Cologne, Germany facility. This is expected to add $10mn of EBITDA in 2023 and going forward. The gas back debottlenecking is a two-year payback we believe is mostly a function of unlocking the ultra-premium gas black. In addition, Orion expects another $6mn of EBITDA from $5mn spent de-bottlenecking a specialty facility in China. Sandra Neuman, head of specialty revealed that Orion has had its top customers on allocation for years in gas black, which is an indication of the demand for its high end products like coating application. Based on conversation with competitors and the company, we think some products Orion sells have GP/Ton between $3,000 and $10,000. While small volume, they can have a large impact on Orion’s profitability.

Kappa Acetylene: Shift to Battery Materials Supplier

While the de bottlenecking and asset upgrades will lead to 10-15% volume growth and additional $10-$20m of EBITDA on an annual basis, the real growth is going to come from Orion’s US based expansion into acetylene black for use in making lithium-ion batteries. At a cost of $130mn at the midpoint, Orion expects the facility to produce between $45-50mn EBTITDA per year at full production and to begin ramping in the second half of 2024. We think the facility can earn after tax returns on capital well north of 25%. If successful and Orion can find another source of acetylene, we think there is an opportunity for at least 1 if not 2 more similar facilities bringing total acetylene for battery EBITDA potential to $80-100mn. Orion already is the sole source provider of Acetylene in Europe after it acquired SN2A from Lyondell in late 2018.

Acetylene is a colorless gas and a byproduct of ethylene production. Orion contracted with Lyondell in Texas for a 15-year offtake agreement where it will then use its reactors to convert the material into a powder. That material is then used to enhance conductivity properties and the movement of electrons within a lithium-ion battery. While a small percentage of the bill of materials, it an absolutely essential element to support conductivity and support battery life. Without the conductive properties it provides, the current does not flow through a battery. Carbon black is the rural road collector: it needs to be dispersed around the active particles to promote conductivity as it connects products within a battery to allow the electrons to flow. 

Outlook and Bridge to 2025

The key takeaway from the analyst day is that Orion needs to spend just $80mn of capex on Kappa in 2023 and the final EPA cap-ex payment of $25mn to grow EBITDA over 50%. In terms of capital allocation, beyond buybacks and a possible dividend increase, any growth capex, will have an associated pay back and EBITDA contribution. Orion’s Adj EBITDA peaked at $292mn in 2018. On an LTM basis the company has already done $280mn despite volumes well below peak. Additionally, as shown below, in 2022 and 2023 Orion will add about $40mn of EBITDA from its facility in Italy and a second in China, which will ramp throughout 2023. Looking out further to 2H 24, the Acetylene facility can add between $45-50mn of EBITDA with contribution margins well above average. Combined, through 2024, Orion’s growth cap-ex investments will generate over $80mn of EBITDA at close to a combined 20% ROIC.


Orion can generate substantial free cash flow driven by greater earnings capacity, better returns on capital and less cap-ex. The Below is a bridge to show the EBITDA and potential FCF over the next few years.

Valuation: What is Orion Worth?

Since 2015, Orion has traded at an averge of 7x EBITDA and a persisent 1-1.5x turn to public peer Cabot. At its peak in 2018-2019, Orion traded close to 9x and troughed during covid about 4.5x. Orion’s return on invested capital is improving and with just $80mn of growth cap-ex remaining in 2023 to hit their $500mn of mid cycle EBITDA estimate, we think by 2024-2025 consolidtated ROIC at Orion should be over 20% against a WACC of 8% using and EV/IC valuation framework implies an EV/EBITDA multiple of 8x or more is justified. Imporatantly, that increase in return on capital will be acommpanied by real free cash flow, something Orion hasn’t delieverd over the last two years to further support the valuation


ESG Overhang and Other Risks

·        We refer investors to the transcript of the recent analyst day where Orion discusses various projects and initiatives it is involved in to make its products most sustainable. The reality is, that if tire manufacturers want to make their tires greener, they have to work with carbon black manufacturers. While just 2-6% of the cost a tire, carbon black can be as much as 25% of the weight. There are limited substitute materials to get the performance of carbon black and there is simply no way to “Green” a tire without them. Orion does use carbon black oil and other heavy hydrocarbon residuals to make their tires – these are not “green” products by any stretch. But the are by products and using them to manufacture tires or other products is a better use for the environment than burning them off. Our view is that carbon black manufacturers will actually be a beneficiary of the transition to electric vehicles over time.

·        Further economic deceleration in China, which could directly affect Orion’s capacity in the region and/or drive more aggressive export behavior on behalf of Chinese tire makers—regardless of tariffs—resulting in indirect pressure on Orion in other regions.  A Chinese slowdown could impact demand for lithium ion batteries as well. 

·        An unanticipated dislocation in energy/refining markets could create feedstock availability and cost headwinds for Orion

·        Near term noise on working capital and oil price driving misguided concerns on borrowing and leverage.


Appendix and Additional Context

Free Cash Flow, Capex, Oil Price and Working Capital

A possible overhang in Orion’s stock is people don’t believe the bridge to 2025. Implicitly, the $500mn Adj EBITDA is the earnings capacity of the business at what Orion believes to be “mid cycle conditions”

Noticeably absent from Orion’s forecast for FCF from 2022-2025 are two things

1. An Oil Price Assumption

2. Working Capital Source/Use of Cash

In its normal investor and earnings materials, Orion is clear to present sensitivities to changes in oil price and the effect on working capital as well as EBITDA. Through Q1, working capital was an $88mn use of cash. The average price of Brent increased from $80 at the end of the year, to $94 at the end of Q1 and its tracking to an average of about $110 for Q2. The impact in the near term on working capital from oil seems relevant as Orion may borrow more on its revolver in 2022, but in 2023 and beyond, as the earnings power increases, the impact will be smaller. 2022 so far feels as its going to be a max pain year for working capital usage given the rapid rise in oil prices following Russia’s invasion of Ukraine. However, Orion has spoken publicly about having enough borrowing capacity to manage up to a $200 oil price. In June, Orion increased its revolving credit facility to provide additional access to capital if needed. These are real uses of cash but they will even out over time and more than anything create noise.


To demonstrate a few different oil price sensitivity and scenarios, we took Orion’s forecast for FCF and then provided a few examples of how much of a use or source of cash things would be from the oil price changing. If oil were to go from $115 in 2022 (current strip) to $175 in 2025, the effect would be a $170mn use of cash between now and then. However, the offset is that EBITDA and earnings power would be increased by $60mn, reducing the cash drag and we don’t account for the difference below. This is a long way of demonstrating that in any given year Orion’s FCF will fluctuate and in years of large oil price movements, they need to have liquidity to help manage – which they do.